The European Union Emissions Trading System (EU ETS) is the world's largest 'cap-and-trade' program designed to reduce industrial greenhouse gas emissions. It works by setting a strict limit (a 'cap') on the total emissions allowed and creating a market where companies can trade emission allowances.
The European Union Emissions Trading System (EU ETS) is the cornerstone of the EU's policy to combat climate change and its key tool for reducing industrial greenhouse gas (GHG) emissions cost-effectively. Launched in 2005, it operates on a “cap and trade” principle, covering over 10,000 heavy-energy-using installations in power generation, manufacturing, and aviation. The system's primary goal is to create a financial incentive for companies to lower their carbon footprint, making pollution a measurable cost.
This regulatory framework is essential for driving decarbonization across Europe. By putting a price on carbon, the EU ETS encourages businesses to invest in more efficient, low-carbon technologies. It directly impacts the operational costs of polluters, rewarding those who innovate and penalizing those who lag behind.
How the EU ETS Works: The “Cap and Trade” Principle
- The Cap: The EU sets a total cap on the amount of greenhouse gases that can be emitted by all participating installations. This cap is gradually lowered over time to ensure that total emissions fall in line with the EU's climate targets.
- Allowances (EUAs): The total emissions under the cap are divided into tradable allowances, known as European Union Allowances (EUAs). One EUA gives the holder the right to emit one tonne of carbon dioxide (CO₂). A significant portion of these allowances are sold at auction by member states.
- The Trade: At the end of each year, companies must surrender enough allowances to cover their total emissions.
- If a company emits less than its allowance allocation, it can sell its spare allowances on the market.
- If a company emits more, it must purchase additional allowances from other participants. This creates a dynamic carbon market where supply and demand determine the price of an EUA.
Concrete Use Case
Imagine two companies under the EU ETS: a coal-fired power plant and a modern gas-fired power plant.
- The Coal Plant: Due to its older technology, it emits a large amount of CO₂. It quickly uses up its allowances and is forced to buy more on the market at the prevailing carbon price, increasing its operating costs and reducing its profitability.
- The Gas Plant: This plant is more efficient and has invested in carbon-reducing technology. It emits less than its allocation, leaving it with a surplus of EUAs. It can sell these surplus allowances to the coal plant, generating an additional revenue stream that rewards its investment in cleaner technology.
This market mechanism, facilitated by the EU ETS, makes clean energy more competitive and accelerates the shift away from fossil fuels. For more information on the specific asset, read our guide on European Union Allowances (EUAs). For official details, refer to the European Commission's EU ETS page.